How and Why To Refinance a Mortgage

April 24, 2009

Finance

There are two things I?d like to cover: Why should I refinance? And, what is the process for refinancing? I think there are some misconceptions and confusion about these, and I?d like to help clear these up, or maybe just give you a better understanding.

Why should I refinance?

Hmmm...a bit much.

Hmmm...a bit much.

The obvious answer is that it will save you money. But it?s more than just your monthly payment going down. You might say, ?But Brad, I have no problem making my payments right now, why should I bother?? If I know you well enough, I might reply ?Hey, if a couple hundred dollars a month really doesn?t matter to you, just write out a check to me for $200 the first of every month, and I?ll come by and pick it up.? That sometimes gets me a laugh. So, let?s take an example. Let?s say you have a $250,000 mortgage, and your current interest rate is 6.5%. Late summer 2008, 6.5% wasn?t too bad. And for those of you too young to remember, in the late 90s, 8% was doing good, and when Carter was in office, mortgage rates were in the teens. So the P&I (principle and interest-payment for the mortgage only, not including taxes and insurance) would be $1,580 per month in this scenario. Now, let?s say we do 5% on this particular loan. For now, I am going to leave out closing costs and other expenses?we?ll get to those below. So $250,000 at 5% is $1,342 a month. That?s over $200 a month, and nothing to sneeze at.

But, let?s elaborate on this a little further. It?s not just a couple hundred of bucks a month. You are also chipping away at the principle faster. How much interest would it be on $250,000 at 6.5%? $250,000 x .065 = $16,250 in interest per year. Now, take $250,000 x .05. That?s only $12,500 in interest per year. If you take 12 payments at the higher rate ($1,580 x 12), that?s $18,960 per year, and at the lower rate ($1,342 x 12) it?s $16,104 per year. So, you?ve save almost $3,000 a year. But, if you subtract the interest from the payments, you can see how much more the principle would go down. At 6.5%, you?d take $18,960 (total payments) – $16,250 (interest paid) = $2,710 toward principle. Now take the 5% loan – $16,104 ? $12,500 = $3,604 applied toward principle. See that? Not only did you save a couple hundred dollars a month, but you paid 30% more toward the principle than you would?ve if you’d kept your old loan. And long term? 360 payments (30 years) times $1580 per month comes out to $568,800 (!) over the life of the loan. $1342 x 360 = $483,120. Not worth it? OK, I?ll stop by your place in 30 years and pick up my check for $85,000.

What else can refinancing do for me?

All right, so you are 40-something, and don?t want to start over with a new 30-year loan. ?Brad, I?ve already got 5 years into my current mortgage. I?d hate to go backwards that much, and I don?t have a problem making my payments where they are at.? Sure, that makes sense. Let?s do a 20 year mortgage. And, let?s make the rate 4.875%, since 15 or 20 year loans usually have a slightly lower rate. $250,000 at 4.875% on a 20-year note is $1,632 per month. So, now, you?ve kept the payments close to the same, but shaved five years off your term. And you?d save a whopping $177,000 over the life of the loan ($391,600 vs. $568,800). Don?t even get me started on what your money could do for you if you took the difference and invested it. And you can do the same thing with a 30-year mortgage. Let?s say you like the lifetime savings, but the payment scares you a bit. That?s $300 a month, you know. If you send in just one extra payment per year, you pay off your loan in about 24 years. So in our above example, send in $1,400 each year from your tax return, or send in $1,476 per month ($1,342+$134), which is still less than the $1,580 per month you were spending, and you save huge over the life of the loan. 24 years times 12 months is 288 months. At $1,476 per month, that?s $425,000 over the life of the loan, which saves you almost $60,000.

So why is my loan amount going up so much?

OK, Brad, you?ve convinced me that it?s worth it to refinance; what comes next? Let?s start off with the nuts and bolts.

Take Interest Into Account

Pay Less Green For Your House?

Pay Less Green For Your House?

Your mortgage payoff is always going to be higher than your principle balance. Mortgage interest accrues daily, and is paid in arrears. When you made your April payment, it paid all of the interest that accrued from March 1- March 31, and your March 1 payment paid the interest from February 1 ? February 28, and so on. So, let?s say you started the refinancing process now, and plan on closing within the first half of May. If your mortgage statement says $249, 345, how much will your payoff be? So you?ve made the April payment, but since we?re closing early May, you can skip your May payment. Let?s say we close May 10, and the loan funds on May 15 (3 day rescission for refinances). We have daily interest then that will accrue from April 1 through May 15, a full month and a half. $250,000 (your original loan amount) x .065 (6.5% interest) = $18,960 of interest in a year, divide by 365 (sometimes 360 is used for this), and we have $51.95 per diem interest. Multiply that by 45 days, and we have $2,337.50 interest to be accounted for. $249,345 + $2,337.50 = a payoff of $251,682, and that?s if there is no escrow shortage or accrued late fees. Plus the title company usually pads the payoff by a couple of days, which you?d get refunded in a couple weeks.

Closing Costs & Fees Happen

Now, we have to add in closing costs. These can vary widely, and depending on the situation and the rate, there may be points involved. But not counting points, you can figure a couple thousand dollar for closing costs. There is always going to be title fees, processing and/or underwriting, maybe some miscellaneous ?junk? fees, county recording fees, etc. Let?s not forget about the per diem interest on the new loan. If we have 15 days of interest (the loan is funding the 15th of May, and your first payment isn?t due until July 1, and interest is paid in arrears), and round to $50 a day, that?s another $750. And you want (or are required to have) escrows for the tax and insurance? Let?s say your taxes are $6,000 per year. That?s $500 per month. Let?s say your insurance is $900 a year, or $75 per month. In Cook County, taxes are due in March and October. (Most of the surrounding counties are June and September.) So, our loan funds in May, and your first payment is July. You make three payments (July, August, September) before your taxes are due. $3,000 is due, but you?ve only paid in $1,500. That means we need to set aside at least $1500 for ?reserves? into the escrow account. And almost always, they add another 2 months ?pad? in case the taxes go up, which does happen inevitably. So let?s make that $4,000 for tax reserves into escrow.

Don’t Forget Homeowner’s Insurance

Let?s say your homeowner?s insurance is also due October 1. Using the same formula as we did for taxes, $900 will be due, but you?ve only paid in $225 with your three payments. So that?s $675 needed in reserves, plus 2 months? pad, for $825 into escrow reserves for insurance. I?d like to mention here that you will likely be getting a refund from your current mortgage company for the monies in your current escrow, if you have one, and they would be close to what we are setting aside in reserves. So if you want to keep your new loan amount down, you could bring in $4800, and you?d be getting a check back for around that amount in 2 to 4 weeks after your current mortgage is paid off.

Bring It All Together

So, the question will pop into your mind ?Why is my mortgage going from $250k up to $260,000???? And the answer is this (rounding for easy math): $252,000 payoff to the current mortgage, plus $2,000 for closing costs, plus $1,000 for per diem interest, plus $5,000 into the escrow account, brings the loan to about $260k. And if it?s an FHA loan, you have 1.5% up-front Mortgage Insurance Premium (MIP), which goes to HUD. In this case that would be $3,900, bringing your loan up to almost $264,000. So that?s how your loan amount can go up ten grand with only a couple thousand in closing costs. But, you have almost as much in increased short term cash flow. Skip two payments (May and June), and that?s over $4k here (including taxes an insurance), and you?re getting almost $5k back from your old escrows. If you want to keep your loan amount down, you could come to the closing with that $9k, and you would not get the benefit of increased short term cash flow, but you wouldn?t have your loan amount going up so much, if that?s a concern. It?s your house, and your mortgage. You decide which way to go.

Oh, Those Underwriters?

Now, obviously I don?t want to scare anybody off from purchasing a home or refinancing; that?s how I make my living. But, I do want to set the right expectations. These days, investors (like Wall St., who buy the loans in bulk from the lenders), are a little skittish about investing in mortgages. So, every lender, every underwriter, and every appraisal reviewer out there wants to make sure they have done their due diligence. They want to make certain that nothing snuck past them on their watch. So it is possible, dare I say probable, that we will be required to produce additional documentation or support above and beyond what would ?normally? be required. Maybe they ask for tax returns or a written verification of employment in addition to 2 pay stubs and 2 W-2s. Maybe they ask for additional sales on the appraisal. Maybe they ask for something that doesn?t seem to make sense to you or me. But, there is likely some sort of reasoning behind it. And the bottom line is that they control the purse strings, and they can ask for whatever they want. They are trying to minimize their risk, and you and I simply have to deal with it. The loan might take a little longer to close. You might have to send a couple extra faxes. But, as long as you know this up front, it?s really not the end of the world. It might be a little more hassle, or a little more time, but 99% of the time, if I tell you I can get your loan done, then it gets done.

We’d like to thank Colin and WoodleyWonderWorks for today’s photo that he so kindly shared via the Creative Common’s License.

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About Brad Walbrun

Brad Walbrun grew up in northeastern Wisconsin, moving to Chicagoland over a decade ago, and never to return, although he remains an avid Packer fan. He is married, with 3 children, living in Schaumburg. Brad's passions are fitness, MMA, and mortgages. He has been in the mortgage industry since before the refi boom, for almost 10 years now. You can reach Brad at (847) 975-4440 or bradwalbrun@hotmail.com.

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